Thursday 3 October 2013

BUDGETING AND BUDGETARY CONTROL

An important Project Management Tool
What is a budget?
·         A Plan
·         A Limit
·         A Schedule
·         A Reality Check
·         An Allocation

Budget – a definition
“A planned expression of money”
   Wright.D 1994 “A practical foundation in costing” Routledge

For a defined activity shows;
·         Income & Expenditure
·         Total estimated costs
·         Defined period of time
Another definition
   A budget process is a system of rules governing the decision-making that leads to a budget, from its formulation, through its legislative approval, to its execution.
   
More definitions
BBudget = Quantitative expression of a plan
A plan expressed in monetary terms, prepared and approved prior to the budget period and which shows income expenditure and the  capital employed. It may be drawn showing incremental effects on former budgeted figures or complied by zero budgeting.
Budgets are therefore not prepared in isolation and then filed away but are concrete components of what is known as a budgetary control system. Such a system essentially ensures communication, coordination and control within an organization. The basic functions of management are allocation of resources, planning and control.BBudgets involve – Planning & Control
·         Budgeting in Context
·         A budget helps
·         Why use a budget?
·         Stay within a limit
·         Control
·         Forecasting
·         Delegate
·         Prioritise Wants, Organise Needs,
·         Within the realm of what we Can
PURPOSE OF A BUDGET
·         Co-ordination- Important for the achievement of organization goals e.g.
·         Coordinate inputs and outputs in order to ensure balance of efforts and effects.
·         Coordinate budget lines within the organization to ensure effective implementation of  plans and monitoring of results.
·         Coordinate responses to economic trends and challenges posed by the environment within which programmes and activities are undertaken
PREPARATION OF THE BUDGET
1. Identify objectives
2. Gather data about alternatives
3. Select alternative courses of action
4. Discuss the plans/activities and allocate the budget.
5. Establish monitoring mechanisms.
6. Respond to problems encountered in the previous budget.
  • Communication: The budget is used to communicate plans and to control information. Once formulated the aspects of the plan having a bearing on a particular division of the organization are communicated to that division.
  • Motivation: The budget seeks to motivate managers to achieve objectives and thereby establish control within the organization
  • Performance Evaluation: a budget is used to evaluate the capability of managers to achieve targets.Good performance is associated with achieving better performance targets set on costs of operations and benefits to the organisation.
  • Authorization: The budget is used to authorize  expenditure or to pursue certain initiatives once a budget is approved:

a.       it becomes a permission to spend.
b.      acceptance that either a project or activities should commence.
DATA FOR BUDGET PROCESS
INTERNAL INFORMATION
  1. Production and operational information
  2. Financial information
  3. Research and development information
  4. Personnel information
  5. Sources of internal information-expected outputs  - performance targets, control and monitoring and evaluation mechanisms.
EXTERNAL INFORMATION
1.      Market and competitors
2.      Economic conditions
3.      Industrial structure
4.      Political factors
5.      Technological change
6.      Demographic trends and social factors
7.      Government statistics, commercial data, banks.
8.      Media coverage, business trips, conferences.
Types of budgeting
There are three common budgeting methods:

1.      Top-down Budgeting
2.      Bottom-up Budgeting
3.      Iterative Budgeting
Top Down Budgeting
         Top-Down Budgeting is the term given to a budgeting process based on estimating the cost of higher level tasks first and using these estimates to constrain the estimates for lower level tasks
         A crucial factor for successfully implementing this method for estimating budgets is the experience and judgement of those involved in producing the overall budget estimate.
Organisations need the ability to allow:
Financial Managers to establish centralised budgets to control organisation spending.
Project Managers to establish projects budgets that consume the centralised organisation budget and control project spending.

Advantages
1.      Takes less time
2.      Promotes upper-level commitment
3.      Involves no multilevel participation Aggregate budget is quite accurate, even though some individual activities subject to large error
4.      Budgets are stable as a percent of total allocation and the statistical distribution of the budget is also stable leading to high predictability
5.      Small costly tasks don’t need to be identified early in this process - factored into overall estimate
6.      Lower management better understands what upper management expects
7.      Presented down the ladder
Disadvantage
1.      Translating long-range budgets into short-range budgets.
2.      Problems scheduling projects in a "sub-optimal way" to meet the strategic goals
3.      Result of top management's limited knowledge of specifics of project tasks and activities
4.      Competition for funds among lower-level managers, try to secure adequate funding for their operations.
5.      May cause unhealthy competition.
6.      This process is a zero sum game--one person's or area's gain is another's loss.
7.      Subordinate managers often feel that they have insufficient budget allocations to achieve the objective

Bottom Up Budgeting
         Sometimes called Zero Based Budgeting
Bottom-up budgeting begins with identifying all the constituent tasks that are involved in implementing a project and working out the resources and funding required by each
Provides the opportunity to create organisation level    budgets by rolling up project budgets
Create centralised project level budgets from their sub-project budgets (WBS)
         Advantages

  • Project Managers have the flexibility to define their project budgets independently
  • Financial Managers have the ability to centrally review the total project budget/s
  • Is in the accuracy of the budgets for individual tasks
  • Clear flow of information
  • Use of detailed data available at project management level as basic source of cost, schedule, and resource requirement information.
  • Participation in the process leads to ownership and acceptance
Disadvantage

  •  Takes more time
  •  Involves cross-section of the organisation
  • Presented up the ladder
  •  Seeks participation at all levels
  •   Encourages commitment to the plan
  • Top management has limited influence over the budgeting process,
  • Individual tend to overstate their resource needs because they suspect that higher management will probably cut all budgets by the same percentage
  • More persuasive managers sometimes get a disproportionate share of resources
  • A significant portion of budget building is in the hands of the junior personnel in the organisation
  • Sometimes critical activities are missed and left unbudgeted
Iterative Budgeting                           Iterative – to repeat or do again
A combination of top-down and bottom-up budget building
·         Higher project level estimated (top down)
·         Lower level costed (bottom up)
·         The two costs negotiated and reconciled
Disadvantage
1.      Is in the relative inefficiency and time consuming nature of the negotiations over the budgets.
2.      Process may not work well when communication channels are either informal or blocked between lower-level managers and senior management
Advantage
1.      It promotes employee involvement and stimulates a high degree of information flow between those involved in the project at different levels
2.      Both senior management and lower level managers closer to the actual process participate in the budgeting process

Top Down vs. Bottom Up
       Top-down           Bottom-up
Problems of Bottom-up Budgeting
1.      Difficult to control aggregate spending
2.      Allocations may not be optimal
3.      Hard to keep multi-year perspective

Top Down & Bottom Up Compared
• Bottom-up                                • Top-down      
      
  - Annual                                             - Multi-year     

  - Time consuming                              - Delegated authority

  - Ownership of proposals is               - Creates joint ownership of
     specific                                              proposals

  - Reactive                                           - Proactive


Activity Orientated Budget
1.      The traditional budget is activity based
2.      Individual expenses classified and assigned to basic budget lines e.g. phone, materials, personnel, clerical, utilities, direct labour, etc
3.      Diffused control so widely that it was frequently non-existent
Task Orientated Budget
Also known as Program Budgeting
Aggregates income and expenditures across programs (projects)
The project has its own budget
Pure project organisation, the budgets of all projects are aggregated to the highest organisational level
Functional organisation income/expense for each project are shown

Planning Programming Budgeting System (PPBS)
  1. The system focuses on funding those projects that will bring the greatest progress toward organisational goals for the least cost
  2. Basically a Program and Planning Budgeting System
  3. Planning Programming Budgeting System (PPBS)
  4. Identification of goals and objectives for each major area of activity - planning
  5. Analysis of the programs proposed to obtain organizational objectives - programming
  6. Estimation of the total costs for each project, including indirect costs. Time phasing of costs is detailed.
  7. Final analysis of alternative projects in terms of costs, expected costs, expected benefits, and expected project lives.
  8. Cost/benefit analyses are performed for each program so programs can be compared with each other and a portfolio of projects can be selected for funding
  9. Budget Planning linked to Project Activity
  10. Only way a detailed budget can be produced
  11. Can monitor budget usage against project activity
  12. Can be done when the project schedule has been determined
  13. Completion Times, Project Activities, Costs
  14. Direct relationship of these items
  15. Will affect the final budgeted figure
  16. Is a “trade off”
Budgetary Control
This is the establishment of a budget relating the responsibilities of executive management to the requirement of a policy and continuos comparison of actual and budgeted results.
Control should ensure that actions are accordance with the objective of the policy in question
Also provides a basis for its revision.
ELEMENTS OF BUDGETARY CONTROL
Setting up budgets i.e. planned targets on revenue, expenses, assets and liabilities relating to the activities concerned.
Measuring actual results against the budgets on a continuous basis
Identifying and analyzing deviations from budgets and modifying both actual operations and subsequent budgets.
MAIN AIMS OF BUDGETARY CONTROL
·         To establish the degree of progress to the achievement of short term plans
·         To allow delegation to occur without losing overall control
·         To provide a measure for allowing flexibility in operations

·         To establish short term plans and aid the organization’s planning process
The ability to control anticipated expenditures for your project using a project cost budget.
   The Projects Budgetary Controls feature includes the following:
  1. Flexible Setup of Controls
  2. Defines Control Amounts
  3. Defines Control Levels
  4. Funds Check - Performs the available funds verifications.
  5. Maintenance of Available Balances - Maintains the available balance for each project budget line.
Actual Transactions;are recorded project costs. 
         Examples include labour, expense report, usage and miscellaneous costs.
Commitment Transactions;
         are anticipated project costs. 
         Examples include purchase requisitions and purchase orders or contract commitments.

Features of an effective budget
1.      Accurate forecasting
2.      Based on organisational goals
3.      Information is timely and accurate
4.      Formed with multilevel input
5.      Regular reviews are built-in

Problems with budgeting
The process is too long
There is a lot of game playing
Business decisions change but the budget does not
People in charge of budget are held accountable in areas where they have no responsibility
Applying an arbitrary percentage to prior period actual

Analysing Variance
·         Budget deviation analysis (variance analysis) regularly compares what you expected or planned to earn and spend with what you actually spent and earned. 
·         Variation analysis can help greatly when detecting how well you’re tracking your plans, how much to accurately budget in the future, where there might be upcoming problems in spending.

Example of a variance report
Date:                      June 30, 2006
                                                        
Account:  Product Development                 MONTH TO DATE
                                
ACCOUNT   REF.   ACTUAL       BUDGET       VARIANCE              %

SALARIES    5025    £48,000           £43,750          - £4,375                      - 10

TRAVEL       6442      £1,500           £1,200                - £300                       - 25

SUPPLIES     5320         £500           £700                    £200                         28.5



Benefits to checking variance
  1. Understand the reason for the differences
  2. Prepare a more accurate budget in the future
  3. Evaluate budget goals
  4. Isolate problems
  5. Identify weak areas
  6. Motivate managers
  7. Communicate with all levels
  8. Forecast
  9. Response to budget warnings
  10. Freeze spending
  11. Freeze activity
  12. Put off “unnecessary” projects activity
  13. Re-schedule/cost your project
  14. Downsize your project




Saturday 15 June 2013

DIVIDEND POLICY

DIVIDEND POLICY
Dividends or Capital Gains?
The ultimate goal of financial managers should be the maximization of shareholder wealth.
Shareholder wealth can be maximized by maximizing the price of the stock.
As we know, the price of the stock is the expected present value of future cash flows.
Dividends or Capital Gains?
In the late 1950s, Myron Gordon proposed modeling price on a firm’s dividends and growth potential:

Optimal Dividend Policy:   To maximize price, an optimal balance must be found between current dividends (D1) and the need for growth (g).

Dividend Irrelevance Theory
Miller and Modigliani showed algebraically that dividend policy didn’t matter:
n    They showed that as long as the firm was realizing the returns expected by the market, it didn’t matter whether that return came back to the shareholder as dividends now, or reinvested.
o     They would see it in dividend or price appreciation.
n    The shareholder can create their own dividend by selling the stock when cash is needed.

Dividend Policy and Stock Price
Dividend Irrelevance Theory:
n    Miller/Modigliani argued that dividend policy should be irrelevant to stock price.

n    If dividends don’t matter, this chapter is irrelevant as well (which is what most of you are thinking anyway).
n     
Dividend Irrelevance Theory

Dividend Irrelevance Theory

Dividends are not in the final equation!
Therefore, dividends are irrelevant to value!

Dividend Irrelevance Theory
But Miller and Modigliani made some unrealistic assumptions in developing their model:
n    Brokerage costs didn’t exist.
n    Taxes didn’t exist.
They made these assumptions to simplify the analysis.
Bird-in-the-Hand Theory
Gordon argued that a dividend-in-the-hand is worth more than the present value of a future dividend.
In essence, he said that the risk premium on the dividend yield is higher than on the growth rate.
Tax Preference Theory
There are three ways in which taxes affect the dividend preferences of shareholders.
n    For individual investors tax rates differ for capital gains and dividends.
n    Taxes on capital gains are not due until the stock is sold.
n    If the stock is held until the shareholder expires, no tax is due at all.
For years the capital gains rate was significantly below the dividend income rate, prompting many companies to retain more income, and declare smaller dividends.
With the Jobs and Growth Tax Relief Reconciliation Act of 2003, the dividend tax rate has fallen sharply.



Dividends or Capital Gains?
Summary:  Do shareholders prefer dividends or capital gains?
n    Dividend IrrelevanceIf the return on investment is what the market requires, then it doesn’t matter whether you get it in dividend or capital gains.
n    Bird in the Hand Theory:  Shareholders prefer dividends, and will require a higher discount rate for capital gains since they are riskier.
Dividends or Capital Gains?
n    Tax Preference Theory Under the old tax system, an unambiguous case could be made in favor of capital gains.  The shareholder would require the same after-tax return, meaning the required return on dividends used to be higher.
o     Today dividends and capital gains have virtually the same tax rate.
Signaling:
n  The theories thus far have assumed that investors and managers have the same information set.
n  When it comes to prospect for the company, managers may have better information than investors.
n  Therefore unexpected changes in dividends may relay information to the market that it didn’t know before.
n     Managers don’t cut dividends unless the firm is in financial distress.
n    It is therefore believed that firms do not increase dividends beyond Wall Street’s expectations unless managers anticipate stronger earnings than expectations.
n    Unexpected changes in dividends relay information to the market.
Clientele Effect Hypothesis
Tax-free foundations and retirees at lower marginal tax rates prefer cash now and on a predictable basis.
Investors at higher marginal tax rates might prefer capital gains to dividends.  With capital gains they can better time their tax liabilities.
Each firm, therefore, attracts the type of investor that likes its dividend policy.
Dividend Policy in Practice
Residual Dividend Policy:  Investors prefer to have the firm retain and reinvest earnings if they can earn a higher risk adjusted return than the investor can.
n  Residual Dividend Policy suggests that dividends should be that part of earnings which cannot be invested at a rate at least equal to the WACC.
Residual Dividend Policy Steps:
1.      Determine the optimal capital budget.
2.      Determine the retained earnings that can be used to finance the capital budget.
3.      Use retained earnings to supply as much of the equity investment in the capital budget as necessary.
4.      Pay dividends only if there are left-over earnings.
Stable, Predictable Dividend Policy: Due to the possibility of a negative signal to investors, many CFOs have set the policy of never reducing their dividends.
n    Dividends are only increased if management is certain future earnings will support such a high dividend.
Stable, Predictable Dividend Policy:
n    A variation of this policy is one in which dividends exhibit a stable, predictable growth rate.
n    In that instance the company has to set the policy in such a way that the growth rate can be sustained for the foreseeable future.
Stable, Predictable Dividend Policy Steps:
1.      Pay a predictable dividend every year.
2.      Base optimal capital budget on residual retained earnings (after dividend).
Constant Payout Ratio Policy:  It is possible that a company could set a policy to payout a certain percentage of earnings as dividends.
n    The problem is that such a policy would not fit the needs of the firms stockholders, since it would cause a great deal of volatility in dividends paid (see clientele effect spoken of earlier).
Constant Payout Ratio Policy Steps:
1.      Pay a constant proportion of earnings (if positive).
2.      Base optimal capital budget on residual retained earnings.
Low Regular Dividend Plus Extras:  This policy is a hybrid of the last two policies.  It is meant to keep expectations low for dividends, and supplement those dividends with bonuses in good years.
n    The problem is the potential for negative signaling.
Low Regular Dividend Plus Extras Steps:
  1. Pay a predictable dividend every year.
  2. In years with good earnings pay a bonus dividend.
  3. Base optimal capital budget on residual of regular dividend and compromising with bonus for capital budgeting projects.
General Motors – Dividends

General Motors – Dividends

General Motors – Dividend History

Caterpillar – Dividend History

Internally Generated Growth
Dividend Payout Ratio:
n    The company can only pay for its own growth if it retains earnings.
n    The stockholder is more certain of earnings if the firm pay out part of “earnings” as dividends.
Retention Ratio:
n    The retention ratio depends on what proportion of earnings is paid-out as dividends.
n    Everything else is retained.
The Internal Growth Rate
The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.
b = Retention Ratio
The Sustainable Growth Rate
The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to  maintain a constant debt ratio.
b = Retention Ratio

Dividend Policy
A company’s dividend policy depends on:
n    The shareholders of the company.
n    Market signaling.
o     The more understandable the better.
o     The more stable the better.
n    The growth potential of the company.